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UPDATED: June 21, 2010 NO. 25 JUNE 24, 2010
Crisis Focus: Europe's Commitment

The ongoing sovereign debt crisis is extracting a painful toll on the European economy. Fiscal sustainability and bleak employment are among the many challenges facing the euro zone. So how should the euro-zone countries restore growth and at the same time ensure their fiscal health? The International Monetary Fund provided answers in its annual review of euro area policies. Edited excerpts follow:

Key downside risks are emanating from concerns about fiscal sustainability and possible adverse feedback between the financial sector and public finances. Delayed or half-hearted fiscal consolidation in countries facing high spreads could trigger further losses of financial market confidence in the fiscal sustainability of some member states, a spike in risk premiums and a sharp depreciation of the euro.

The current euro-area crisis has resulted from fiscally unsustainable policies in some countries, delayed maintenance of the financial system, insufficient progress in establishing the discipline and flexibility needed for a smooth functioning of the monetary union, and deficient governance of the euro area.

The immediate crisis response has been bold, demonstrating the euro area's capability to act together when pushed to do so. In this context, it will be imperative to quickly secure the operation of the European Financial Stability Facility. But crisis management is not an alternative to the corrective policy actions and fundamental reforms needed to reinforce the foundation of the European Monetary Union.

Prior to recent sovereign jitters, growth in the euro area was expected to be moderate and uneven, marked by high and persistent unemployment and subdued investment. Despite supportive fiscal, financial and monetary policies—which stabilized demand—growth remains weak in the euro area and divergent across member states.

While policies and institutions limited the rise in unemployment on average, its counterpart was a significant decline in productivity across all sectors in the euro area. Hence, new job creation will be limited during the upswing. Lending constraints are weighing on demand of a significant number of households and small and medium-sized enterprises. Robust global demand and the weaker euro are helping the export sector, but rigidities, especially in labor and financial markets in some countries, are limiting the necessary restructuring in the aftermath of the global crisis and hampering the efficient reallocation of labor and capital.

While the recently established crisis management framework should limit abrupt movements, lack of sustained fiscal and structural policy adjustment could further sap business and consumer confidence, possibly undoing the impetus stemming from the global recovery and even adversely affecting the global economy.

The longstanding problem of anemic growth in the euro area must now be addressed—higher growth is not only important for its own sake, but essential to help secure fiscal sustainability and strengthen the cohesion of the euro area.

Key reforms for economic growth include: making the labor market more effective, removing disincentives to work embedded in various public policies, enhancing wage bargaining flexibility, and further liberalizing services sectors. Other measures should target tax compliance, licensing restrictions, non-tariff trade barriers, and foreign ownership and investment restrictions. Distortions to competition in the banking sector should be removed, including a phasing out of public ownership stakes. A renewed commitment to liberalizing trade and avoiding disguised forms of protectionism would also be welcome.

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